The role of central counterparties in securities lending
19 November 2020
Options Clearing Corporation’s Matt Wolfe details how the US equity derivative clearinghouse has gone above and beyond to ensure its members are protected from defaults and extreme market volatility
Image: Matt Wolfe
Many readers of Securities Finance Times will have some level of understanding about central counterparties (CCPs) and Options Clearing Corporation (OCC), while some may not be familiar with the role of CCPs or OCC in the securities lending marketplace. We thought an excerpt from a recently-published OCC paper on central clearing would provide a good refresher for some readers and a good introduction for others. As a systemically important financial market utility (SIFMU), OCC has invested heavily in its systems, processes, and people to promote stability and integrity in the markets it serves. We utilise sophisticated tools to measure various types of risk to ensure we hold a sufficient, but not excessive, level of collateral to guarantee that the contracts that we clear are fulfilled. As you will see from reading our paper, we are transparent about our risk management framework and encourage industry participants to understand and learn from us.
Despite OCC’s history of clearing securities lending transactions since 1993, the buy-side of the market, specifically agent lenders and beneficial owners, have not yet had a chance to realise the benefits of OCC’s clearance, settlement, and risk management services. We are striving towards this goal, and hopefully this introduction will be particularly informative to those participants.
Clearinghouses are critical market infrastructures that have functioned remarkably well since their inception, and their performance during the 2008 financial crisis ushered in a new embrace of central clearing as a proven risk mitigant for financial markets. Throughout those volatile times, cleared markets continued their orderly and transparent function to the benefit of the investing public and the economy at large.
Policymakers in the US and around the world took notice and mandated that a number of previously-uncleared markets should be restructured to reap the benefits of CCP risk management. The resulting increase in CCPs’ systemic importance also led to significantly enhanced regulatory requirements and guidance for CCPs across jurisdictions. During the past decade, CCPs committed unprecedented resources to delivering the enhanced financial and operational resilience demanded by policymakers, regulators and market participants. CCPs’ smooth functioning during the dramatic markets of this year’s pandemic demonstrates that these efforts are serving the markets well.
OCC, founded in 1973, is the world’s largest equity derivatives clearing organisation. OCC operates under the jurisdiction of both the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). In addition, OCC has been designated by the Financial Stability Oversight Council as a SIFMU under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). As a SIFMU, OCC is also subject to oversight by the Board of Governors of the Federal Reserve System. OCC is the sole clearing agency for exchange-listed equity options in the US and operates as a market utility.
OCC, clearing firms, exchanges, and market participants have a common interest in maintaining a robust risk management framework so that defaults are rare, and that in the unlikely event that there is a clearing member default, the prefunded financial resources of the defaulting clearing member can, in most cases, cover its obligations to OCC. This is the fundamental characteristic of a ‘defaulter pay’ model, and, we believe, the cornerstone of CCP resilience.
Evolution of CCPs and CCP regulation
CCPs provide markets with risk mitigation through counterparty substitution whereby the CCP becomes the counterparty to every trade—the buyer to every seller and a seller to every buyer. CCPs also engage in multilateral netting, which reduces the risk in the overall system. As the first line of defence against a default, CCPs establish membership criteria and monitor their members against these criteria. CCPs also collect margin to cover the expected period from the time of a default until the positions are closed out. Portfolios are marked-to-market, evaluated throughout the trading day, and settled at least once a day (they can also be settled intra-day). In addition, CCPs establish default funds, typically funded by their members, to cover potential exposure to the nonperformance of any member, thus mutualising the risk of member failure. CCPs also have default management procedures and can draw on pre-funded resources, known as the default waterfall, to assist them in managing a default. Finally, CCPs have in place recovery and wind-down plans.
The success of the CCP model was perhaps best demonstrated when handling the Lehman Brothers bankruptcy during the financial crisis of 2008. As Peter Norman described in his book, Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets: “Within a week of the Lehman bankruptcy, most outstanding open positions relating to these trades had been neutralised or ‘hedged’ ... within two weeks, most of Lehman’s customers were transferred to other investment companies. By late October 2008, CCPs in most leading financial markets had reported success in managing the biggest default in financial history without cost to their member companies.”
OCC’s perspective on CCP resiliency, recovery and resolution
OCC is a registered clearing agency under SEC jurisdiction, clearing US exchange-listed options and securities lending transactions. As a registered derivatives clearing organisation (DCO) under CFTC jurisdiction, OCC clears transactions in futures and options on futures. This is a fairly narrow product mix. For example, OCC does not clear over-the-counter (OTC) derivatives. As a registered clearing agency, OCC is a self-regulatory organisation under the Securities Exchange Act of 1934. Self-regulatory organisations are charged with an important public trust to carry out their self-regulatory responsibilities effectively and fairly, while fostering free and open markets, protecting investors, and promoting the public trust.
OCC operates as an industry utility and its governance and business model is different from publicly-traded or vertically integrated CCPs. OCC is owned by five options exchanges and governed by a board of directors that includes nine clearing member representatives, five exchange representatives, five public directors and one management representative. As a result, 70 percent of the board is composed of clearing members and public directors.
OCC is the sole clearing agency for listed equity options in the US and, as noted, operates as a market utility. Over 95 percent of OCC’s revenue is generated from clearing fees, and OCC manages its resources under an SEC-approved Capital Management Policy that establishes how OCC sets its target regulatory capital level, how clearing fees are set, and how it will manage its capital in relation to defined thresholds. For example, capital exceeding the target capital requirement and not needed for investment in OCC’s infrastructure or initiatives is used to lower the cost of participation in the markets we clear, first as skin-in-the-game and second as a basis for reduced clearing fees or refunds.
To strengthen its risk management framework given its designation as a SIFMU, OCC has embarked on a transformation during the past five years. As part of this transformation, we have made material enhancements to our margin methodology, revised our default fund methodology, implemented a new approach to liquidity stress testing, and elaborated and obtained approval for our recovery and wind-down plan.
OCC is the first derivatives clearinghouse in the world to use a large-scale Monte Carlo-based risk management methodology. We have put in place a sophisticated and conservative margin methodology called the System for Theoretical Analysis and Numerical Simulations, or STANS. As part of this methodology, OCC has adopted a conservative approach related to the confidence level that the initial margin would be sufficient to cover losses incurred in liquidating an individual portfolio. In addition, OCC applies margin add-ons to address concentration, wrong way, liquidity, and de-correlation risks, using a 10-year lookback as an anti-procyclicality tool.
In 2018 we enhanced and changed our methodology for determining the size of our default fund, driven by enhanced stress testing capabilities that include a range of historical and hypothetical market events, including ‘extreme but plausible’ scenarios. This includes a ‘cover two’ approach that allows OCC to cover the concurrent default of its two largest clearing firms that would generate the largest aggregate credit exposure in ‘extreme but plausible’ market conditions. This approach exceeds US regulatory standards applicable to OCC and better aligns OCC with other systemically important derivative clearing houses.
Additionally, we have implemented a new approach to liquidity stress testing and determining the adequacy, sizing, and sufficiency of OCC’s liquidity resources. OCC’s liquidity risk management framework is designed to ensure that OCC holds sufficient qualified liquid resources to meet settlement obligations with a high degree of confidence under a wide range of foreseeable stress scenarios, including the default of the clearing member organisation or group that would generate the largest aggregate payment obligation in extreme but plausible market conditions, which is the US ‘cover one’ standard.
Finally, in the unlikely event that OCC’s pre-funded resources are depleted and credit and liquidity shortfalls remain, OCC has a defined set of recovery tools in its ‘rules and its recovery and orderly wind-down plan’ (approved by the SEC in August 2018) to ensure that it continues to deliver clearing and settlement services, which is in clearing members’, exchanges’, and market participants’ interest. These recovery tools include clearing member assessments, voluntary contributions by clearing members, voluntary tear-ups, and involuntary partial tear-ups.
I hope this provides a good perspective as to how carefully we think about risk management at OCC. In addition to our CCP paper, you can learn more about OCC’s recovery and wind-down plan on our website. We encourage the readers of Securities Finance Times to read our CCP paper and reach out to us to learn more about our clearance and settlement services.
Despite OCC’s history of clearing securities lending transactions since 1993, the buy-side of the market, specifically agent lenders and beneficial owners, have not yet had a chance to realise the benefits of OCC’s clearance, settlement, and risk management services. We are striving towards this goal, and hopefully this introduction will be particularly informative to those participants.
Clearinghouses are critical market infrastructures that have functioned remarkably well since their inception, and their performance during the 2008 financial crisis ushered in a new embrace of central clearing as a proven risk mitigant for financial markets. Throughout those volatile times, cleared markets continued their orderly and transparent function to the benefit of the investing public and the economy at large.
Policymakers in the US and around the world took notice and mandated that a number of previously-uncleared markets should be restructured to reap the benefits of CCP risk management. The resulting increase in CCPs’ systemic importance also led to significantly enhanced regulatory requirements and guidance for CCPs across jurisdictions. During the past decade, CCPs committed unprecedented resources to delivering the enhanced financial and operational resilience demanded by policymakers, regulators and market participants. CCPs’ smooth functioning during the dramatic markets of this year’s pandemic demonstrates that these efforts are serving the markets well.
OCC, founded in 1973, is the world’s largest equity derivatives clearing organisation. OCC operates under the jurisdiction of both the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). In addition, OCC has been designated by the Financial Stability Oversight Council as a SIFMU under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). As a SIFMU, OCC is also subject to oversight by the Board of Governors of the Federal Reserve System. OCC is the sole clearing agency for exchange-listed equity options in the US and operates as a market utility.
OCC, clearing firms, exchanges, and market participants have a common interest in maintaining a robust risk management framework so that defaults are rare, and that in the unlikely event that there is a clearing member default, the prefunded financial resources of the defaulting clearing member can, in most cases, cover its obligations to OCC. This is the fundamental characteristic of a ‘defaulter pay’ model, and, we believe, the cornerstone of CCP resilience.
Evolution of CCPs and CCP regulation
CCPs provide markets with risk mitigation through counterparty substitution whereby the CCP becomes the counterparty to every trade—the buyer to every seller and a seller to every buyer. CCPs also engage in multilateral netting, which reduces the risk in the overall system. As the first line of defence against a default, CCPs establish membership criteria and monitor their members against these criteria. CCPs also collect margin to cover the expected period from the time of a default until the positions are closed out. Portfolios are marked-to-market, evaluated throughout the trading day, and settled at least once a day (they can also be settled intra-day). In addition, CCPs establish default funds, typically funded by their members, to cover potential exposure to the nonperformance of any member, thus mutualising the risk of member failure. CCPs also have default management procedures and can draw on pre-funded resources, known as the default waterfall, to assist them in managing a default. Finally, CCPs have in place recovery and wind-down plans.
The success of the CCP model was perhaps best demonstrated when handling the Lehman Brothers bankruptcy during the financial crisis of 2008. As Peter Norman described in his book, Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets: “Within a week of the Lehman bankruptcy, most outstanding open positions relating to these trades had been neutralised or ‘hedged’ ... within two weeks, most of Lehman’s customers were transferred to other investment companies. By late October 2008, CCPs in most leading financial markets had reported success in managing the biggest default in financial history without cost to their member companies.”
OCC’s perspective on CCP resiliency, recovery and resolution
OCC is a registered clearing agency under SEC jurisdiction, clearing US exchange-listed options and securities lending transactions. As a registered derivatives clearing organisation (DCO) under CFTC jurisdiction, OCC clears transactions in futures and options on futures. This is a fairly narrow product mix. For example, OCC does not clear over-the-counter (OTC) derivatives. As a registered clearing agency, OCC is a self-regulatory organisation under the Securities Exchange Act of 1934. Self-regulatory organisations are charged with an important public trust to carry out their self-regulatory responsibilities effectively and fairly, while fostering free and open markets, protecting investors, and promoting the public trust.
OCC operates as an industry utility and its governance and business model is different from publicly-traded or vertically integrated CCPs. OCC is owned by five options exchanges and governed by a board of directors that includes nine clearing member representatives, five exchange representatives, five public directors and one management representative. As a result, 70 percent of the board is composed of clearing members and public directors.
OCC is the sole clearing agency for listed equity options in the US and, as noted, operates as a market utility. Over 95 percent of OCC’s revenue is generated from clearing fees, and OCC manages its resources under an SEC-approved Capital Management Policy that establishes how OCC sets its target regulatory capital level, how clearing fees are set, and how it will manage its capital in relation to defined thresholds. For example, capital exceeding the target capital requirement and not needed for investment in OCC’s infrastructure or initiatives is used to lower the cost of participation in the markets we clear, first as skin-in-the-game and second as a basis for reduced clearing fees or refunds.
To strengthen its risk management framework given its designation as a SIFMU, OCC has embarked on a transformation during the past five years. As part of this transformation, we have made material enhancements to our margin methodology, revised our default fund methodology, implemented a new approach to liquidity stress testing, and elaborated and obtained approval for our recovery and wind-down plan.
OCC is the first derivatives clearinghouse in the world to use a large-scale Monte Carlo-based risk management methodology. We have put in place a sophisticated and conservative margin methodology called the System for Theoretical Analysis and Numerical Simulations, or STANS. As part of this methodology, OCC has adopted a conservative approach related to the confidence level that the initial margin would be sufficient to cover losses incurred in liquidating an individual portfolio. In addition, OCC applies margin add-ons to address concentration, wrong way, liquidity, and de-correlation risks, using a 10-year lookback as an anti-procyclicality tool.
In 2018 we enhanced and changed our methodology for determining the size of our default fund, driven by enhanced stress testing capabilities that include a range of historical and hypothetical market events, including ‘extreme but plausible’ scenarios. This includes a ‘cover two’ approach that allows OCC to cover the concurrent default of its two largest clearing firms that would generate the largest aggregate credit exposure in ‘extreme but plausible’ market conditions. This approach exceeds US regulatory standards applicable to OCC and better aligns OCC with other systemically important derivative clearing houses.
Additionally, we have implemented a new approach to liquidity stress testing and determining the adequacy, sizing, and sufficiency of OCC’s liquidity resources. OCC’s liquidity risk management framework is designed to ensure that OCC holds sufficient qualified liquid resources to meet settlement obligations with a high degree of confidence under a wide range of foreseeable stress scenarios, including the default of the clearing member organisation or group that would generate the largest aggregate payment obligation in extreme but plausible market conditions, which is the US ‘cover one’ standard.
Finally, in the unlikely event that OCC’s pre-funded resources are depleted and credit and liquidity shortfalls remain, OCC has a defined set of recovery tools in its ‘rules and its recovery and orderly wind-down plan’ (approved by the SEC in August 2018) to ensure that it continues to deliver clearing and settlement services, which is in clearing members’, exchanges’, and market participants’ interest. These recovery tools include clearing member assessments, voluntary contributions by clearing members, voluntary tear-ups, and involuntary partial tear-ups.
I hope this provides a good perspective as to how carefully we think about risk management at OCC. In addition to our CCP paper, you can learn more about OCC’s recovery and wind-down plan on our website. We encourage the readers of Securities Finance Times to read our CCP paper and reach out to us to learn more about our clearance and settlement services.
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